A Well Thought Out Plan? Or, An Unhappy, Costly, and Acrimonious Disagreement?

One of your wealthy clients is co-owner of a successful business. On her daily walk, she is hit and killed by a car, becoming one of the 6,000 pedestrian fatalities which occur in the United States every year.[1]   

This is a horrifying tragedy which occurs all too often. After family, friends, and fellow co-owners of the business get over the shock of her death, a key priority is valuing her share of the business. This is a time when things may go smoothly or dissolve into an unhappy, costly, and acrimonious disagreement. Avoiding this scenario is the reason your client should have a tightly written buy-sell agreement drawn by an attorney who specializes in this area. Such a document will ensure the proper valuation of her ownership interest.[2]  

I’m certain you have clients who are co-owners of a business. You need to probe these clients and ask if they have a buy/sell agreement in place. If not, point out that in the absence of such an agreement the transition could become a wrestling match. Such a rancorous disagreement can do significant damage to the reputation and earning power of a business, which can easily reduce the amount of money the decedent’s beneficiary will receive. During my years in practice, I had people come to me for advice when such an agreement should have been in place but wasn’t. I’ve seen the wreckage which can occur, and it isn’t pretty.

 I would go so far as to say you should consider a buy/sell agreement as a critical part of the financial underpinning of a business with more than one owner. What does this agreement accomplish? “…a buy-sell agreement acts as a sort of ‘premarital agreement’ to protect everyone's interests...” [3]  I know this description of buy/sell agreements from Investopedia sounds unusual, but it is a good analogy and one you can use with clients to illustrate the issues addressed by the agreement.

At its most basic, such an agreement has three key provisos. The first stipulates what specific events trigger the buy/sell agreement. As you might imagine, the most common are death or disability.       

The second key proviso specifies the exact method that will be used to value the decedent’s share of the business. This can be a predetermined valuation which is periodically updated or an agreed upon method of valuation. Heirs will often believe the worth of the business is being undervalued. But a properly executed buy-sell agreement is legally binding on all parties so no one can bring the process to a halt.

The third proviso names the persons legally entitled to purchase the ownership interest of the deceased. In almost every case, buy/sell agreements stipulate that the surviving partner or partners must buy the ownership interest of the decedent. The corollary of the decedent’s beneficiary must sell at a price determined by the valuation method outlined in the buy/sell agreement.

Substantial funds can be required to execute the provisions of a buy/sell agreement. Because of its cost efficiency, life insurance is typically used to fund the buyout upon the death of one of the principals. Proceeds from the policy give the remaining owners immediate access to cash. This infusion of funds prevents them from having to use their own assets to secure the needed funds. Disability insurance works the same in the event of a partner becoming disabled.

As for using life insurance, there are two methods to consider with each method being particular to a specific situation. The cross purchase method is most often used when there are only two or three partners. Each has a policy on the other based on their respective ownership interest. If there are more than three partners, the entity method would likely make more sense.  In this method, the company buys life insurance policies on every one of the owners, pays the premiums, and owns the policies. If an owner passes away, the company receives the insurance proceeds which are then used to purchase the outstanding shares from the decedent’s beneficiary.

Be passionate about how much you can help your clients with your knowledge. People will hesitate to take measures that just affect them, but they will usually act if you show them how damaging and painful such a scenario can be to the people they love.

Resources:

[1] https://tinyurl.com/USpedestrian-fatalities

[2] https://tinyurl.com/ababuysell

3] https://www.investopedia.com/exam-guide/cfp/documentation/cfp5.asp

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Contributing Writer: Subject Matter Expert Charles McCain